ENGINEERING ECONOMY –

INTRODUCTION 23.02.2021
Ekonomi Teknik – 02 (Reguler) ENGE 600 011
Nabila Putriyandri Alifa S.T., M.Sc.
▪ CPMK 1 : Mahasiswa mampu mengkalkulasi equivalensi nilai uang (C3)
▪ CPMK 2 : Mahasiswa mampu mengkalkulasi nilai rate of return, inflasi,
rasio benefit cost ratio, break even point dan sensitivitas (C3)
▪ CPMK 3 : Mampu menganalisis arus kas secara komprehensif dengan
memperhitungkan nilai depresiasi, inflasi dan pajak (C4)
▪ Book :
▪ Blank, L and Tarquin, A, Engineering Economy, 7th ed.,
McGrawhill, New York, 2012
▪ Other References:
▪ Sullivan, W., Bontadelli, J. And Wicks, E., Engineering
Economy, 11th ed., Prentice Hall Inc., New Jersey, 2000
▪ Stermole, F. M., Economic Evaluation and Investment Decision
Methods,Golden, 1984
▪ Berdasarkan capaian pembelajaran Mata CPMK Intrumen Bobot
Tugas/ Quiz (15%)
Kuliah : CPMK 1 30 %
UTS (15%)
▪ CPMK 1: Mahasiswa mampu mengkalkulasi equivalensi
Tugas / Quiz (25%)
nilai uang (C3) CPMK 2 45 %
▪ Topik: Time value of Money; Combining Factors; Interest Rate; Money UAS (20%)
worth Analysis Tugas Quiz (15%)
CPMK 3 25%
▪ CPMK 2: Mahasiswa mampu mengkalkulasi nilai rate of UAS (10%)
return, inflasi, rasio benefit cost ratio, break even point dan
sensitivitas (C3)
▪ Topik: Rate of Return analysis; Benefit/Cost Analysis- Break Even
Point Analysis; Sensitivity Analysis; Cost Estimation; Capital
Budgeting & Replacement
▪ CPMK 3: Mampu menganalisis arus kas secara
komprehensif dengan memperhitungkan nilai depresiasi,
inflasi dan pajak (C4)
▪ Topik : Effects of Inflaction; Depreciation; Tax Analysis
WHY IS ENGINEERING ECONOMY NEEDED?
 THE ANSWER : Engineers must work within the realm of
economics and justification
Engineers must be concerned with the
economic aspects of designs and projects
they recommend and perform

Engineers Engineers
“Design” “Project”

• Analysis • Work with limited funds (capital)

• Design • Capital is not unlimited – rationed
• Synthesis • Capital does not belong to the firm
• Belongs to the Owners of the firm
• Capital is not “free”, it has a “cost”
THE ANSWER
▪ Knowledge of Engineering Economy will have a significant impact
on you, personally.
▪ Make proper economic comparisons
▪ In your profession
▪ Private sector
▪ Public sector

▪ In your personal life

 WHY?
ENGINEERING ECONOMY is involved :

The Formulation,

The Estimation
1

The Evaluation
OF ECONOMIC OUTCOMES WHEN
ALTERNATIVES TO ACCOMPLISH A
DEFINED PURPOSE ARE AVAILABLE
WITH THE APPLICATION OF
DEFINED MATHEMATICAL
RELATIONSHIPS THAT AID IN THE
COMPARISON OF ECONOMIC
ALTERNATIVES
THE ROLE IN DECISION
MAKING
THE ROLE
a set of tools that aid in decision making – but will
not make the decision for you

People make decisions – not “tools”

estimates of future events – the future, the risk and

uncertainty
THE ROLE
The parameters within an engineering economy problem can and
will vary over time.

Parameters that can vary will dictate a numerical outcome

Sensitivity Analysis plays a major role in the assessment of most,

if not all, engineering economy problems

The use of spreadsheets is now common, and students need to

master this valuable tool as an analysis aid
THE DECISION MAKING
• Decide what will be done next → The future
• Best estimate what is expected to occur
• Involve:
• Cash Flows
• Times of occurrence of cash flows
• Interest Rates for time value of money
• Measure of Economic for selecting an alternative
THE TIME VALUE OF MONEY

The change in the amount of money over a

given time period is called the time value
of money; by far, the most important
concept in engineering economy

• Time Value of Money

• Money can “make” money if Invested
• Centres around an interest rate
• Will be explained in Next Lecture
▪ Problem Identification
▪ Collect relevant & available data
▪ Make realistic cashflow estimates
▪ Identify the economic worth criterion for
decision making
▪ Evaluate the alternative
▪ Best Alternative selection
▪ Implementation and monitoring
First cost (investment amounts)

Estimates of useful or project life

Estimated future cash flows (revenues and expenses and salvage values)

Interest rate

Inflation and tax effects

 •Each problem will have at least one
alternative – DO NOTHING
• May not be free and may have future
costs associated

▪ Goal: Define, Evaluate, Select and Execute • Do not overlook this option!

Do
Nothing
Alt. 1 Mutually Exclusive
•Select One and only one from a set of feasible
alternatives
• Once an alternative is selected, the remaining
The Question: alternatives are excluded at that point.
Which One do we
accept?
• Goal: Define, Evaluate, Select and Execute

Do
Nothing
Alt. 1
………... Alt. n

Which one do we accept?

• If all of the proposed alternatives are not
economically desirable then…
• One usually defaults to the DO-NOTHING
alternative
 Estimate flows of money coming into the
firm – revenues salvage values, etc.
(magnitude and timing) – positive cash
flows

– Estimates of investment costs, operating

costs, taxes paid – negative cash flows
• Taxes represent a significant negative cash flow to the for-profit firm.
• A realistic economic analysis must assess the impact of taxes.
•Not considering taxes is called a BEFORE-TAX Cash Flow analysis.
•A Before-Tax cash flow analysis (while not as accurate) is often
performed as a preliminary analysis.
• Called and AFTER-TAX cash flow analysis
•A final, more complete analysis should be performed using an
After-Tax analysis
• Both are valuable analysis approaches
INTEREST - MANIFESTATION OF THE TIME VALUE OF MONEY. THE AMOUNT
PAID TO USE MONEY. Can be seen in

(a)Lending situation •(b)Investing situation

LOAN (Paid) INVESTMENT (Earned)

INTEREST = TOTAL OWED NOW - INTEREST = VALUE NOW - ORIGINAL AMOUNT
ORIGINAL AMOUNT
▪ When interest earned/paid over specific time unit and expressed in % = Interest rate
▪ INTEREST RATE - EXPRESSED PER TIME UNIT (EX: Per Year)

INTEREST ACCRUED PER TIME UNIT

INTEREST RATE (%) = x 100%
ORIGINAL AMOUNT
•Company A borrow $10,000 for one full year; Must pay back $10,700 at the end of
one year
• Interest Amount (I) = $10,700 - $10,000 = = $700 for the year
•Interest rate (i) =
•The $700 represents the return to the lender for this use of his/her funds for one
year INTEREST ACCRUED PER TIME UNIT
ORIGINAL AMOUNT x 100% =
700
10000 𝑥 100% = 7%/y
• 7% is the interest rate charged to the borrower
• 7% is the return earned by the lender
• Bapak A menginvestasikan dananya sebesar $20,000 dalam 1
tahun dengan interest rate sebesar 9% per tahun. Tentukan dana
yang akan didapatkan Bapak A dalam 1 tahun!

INTEREST ACCRUED PER TIME UNIT

INTEREST RATE (%) = x 100%
ORIGINAL AMOUNT
•Interest yang didapatkan = (0.09)($20,000) = $1,800
• Dana yang didapatkan setelah 1 tahun = $20,000 + $1,800 = $21,800
•Perhitungan di akhir tahun 1 = $20,000 + (0.09)($20,000) =$20,000(1.09) = $21,800

•Artinya :
• Bapak A mendapatkan uangnya kembali sebesar $20,000 + mendapatkan return 9% atau
$1,800 setelah 1 tahun.
• A social-economic occurrence in which there is more
currency competing for constrained goods and services
• Where a country’s currency becomes worth less over time,
thus requiring more of the currency to purchase the same
amount of goods or services in a time period

Example : ?
 Extreme inflation

Lebanese Inflation Hits Record High as Food Prices Soar 400% - Bloomberg
• Specific symbols and their respective definitions have been developed
for use in engineering economy.
• Symbols tend to be standard in most engineering economy texts world-
wide.
• Mastery of the symbols and their respective meanings is most
important in understanding the subsequent material!
•For many engineering economy problems:
• Involve the dimension of time
• At least 4 of the symbols { P, F, A, i% and n }
• At least 3 of 4 are either estimated or assumed to be known with
certainty.
• P = value or amount of money at a time
designated as the present or time 0.
• Also, P is referred to as present worth (PW),
present value (PV), net present value (NPV),
discounted cash flow (DCF), and capitalized
cost (CC); dollars
• F = value or amount of money
at some future time.
• Also, F is called future worth
(FW) and future value (FV);
dollars
 • A = series of consecutive, equal,

A end-of-period amounts of money.

•Also, A is called the annual worth (AW) and
equivalent uniform annual worth (EUAW);
dollars per year, dollars per month

n • n = number of interest periods; years,

months, days
i • i = interest rate or rate of return per time period; percent
per year, percent per month

t • t = time, stated in periods; years, months, days, etc

•The interest rate i is assumed to be a compound rate, unless specifically

stated
as “simple interest”

•The rate i is expressed in percent per interest period; for example, 12% per
year.
 P F $F

• The symbols P and F represent one-time

occurrences:
• Specifically:
0 1 2 … … n-1 n t=n

$P

•It should be clear that a present value P represents a single sum of money at some
time prior to a future value F
•This is an important basic point to remember
• It is important to note that the symbol A always represents a
uniform amount (i.e., the same amount each period) that
extends through consecutive interest periods.
• Cash Flow diagram for annual amounts
might look like the following:
$A $A $A $A $A

…………
0 1 2 3 .. N-1 n

A = equal, end of period cash flow amounts

• Engineering Economy has developed a graphical technique for presenting a problem
dealing with cash flows and their timing.
• It’s called a CASH FLOW DIAGRAM
• It’s similar to a free-body diagram in statics
• First, some important TERMS . . . .

•CASH INFLOWS (Arus Kas Masuk)

• Money flowing INTO the firm from outside
• Revenues, Savings, Salvage Values, etc.

• CASH OUTFLOWS (Arus Kas Keluar)

• Disbursements
• First costs of assets, labor, salaries, taxes paid, utilities, rents, interest, etc.
• For many practical engineering economy problems, the cash flows must be:
• Assumed known with certainty
• Estimated
• A range of possible realistic values provided
• Generated from an assumed distribution and simulated

•A NET CASH FLOW is Cash Inflows – Cash Outflows (for a given time period)
• We normally assume that all cash flows occur:
• At the END of a given time period
• End-of-Period Assumption
• END-OF-PERIOD Convention
ALL CASH FLOWS ARE ASSUMED TO OCCUR AT THE END OF AN
INTEREST PERIOD EVEN IF THE MONEY FLOWS AT TIMES
WITHIN THE INTEREST PERIOD.
THIS IS FOR SIMPLIFICATION PURPOSES
• Extremely valuable analysis tool
• First step in the solution process
• Graphical Representation on a time scale
• Does not have to be drawn “to exact scale”
• But should be neat and properly labeled
• Required on most in-class exams and part of the grade for the problem at hand

IMPORTANT !
• Assume a 5-year problem
• The basic time-line is shown below

• “Now” is denoted as t = 0
 Positive CF at t = 1

• A sign convention is applied

• Positive cash flows are
normally drawn upward
from the time-line
• Negative cash flows are
normally drawn
downward from the time-
line
Negative CF’s at t = 2 & 3
• Before solving, one must decide upon the perspective of the problem
• Most problems will present two perspectives
• Assume a borrowing situation; for example:
• Perspective 1: From the lender’s view
• Perspective 2: From the borrower’s view
• Impact upon the sign convention
• Assume $5,000 is borrowed and payments are $1,100 per year.
• Draw the cash flow diagram for this
• First, whose perspective will be used?
• Lender’s or the Borrower’s ? ? ?
• Problem will “infer” or you must decide….
• From the Lender’s Perspective

A = +$1,100/yr

0 1 2 3 4 5

-$5,000
• From the Borrower’s Perspective

P = +$5,000

0 1 2 3 4 5

A = -$1,100/yr
• A father wants to deposit an unknown lump-sum amount into an
investment opportunity 2 years from now that is large enough to
withdraw $4,000 per year for state university tuition for 5 years
starting 3 years from now.
• If the rate of return is estimated to be 15.5% per year, construct the
cash flow diagram.
•A father wants to deposit an unknown lump-sum amount into an investment opportunity 2 years
from now that is large enough to withdraw $4,000 per year for state university tuition for 5 years
starting 3 years from now.
• Example
• Is “68” equal to “110”?
• You travel at 68 miles per hour
• No, not in terms of absolute
• Equivalent to 110 kilometers
numbers
per hour
• But they are “equivalent” in
• Thus:
terms of the two measuring
• 68 mph is equivalent to 110 scales
kph
• Miles
• Using two measuring scales
• Kilometers
• Miles and Kilometers
Economic Equivalence - a fundamental concept
upon which engineering economy computations
are based
• Two sums of money at two different points in time
can be made economically equivalent if:
• We consider an interest rate and,
• Number. of time periods between the two sums

Equality in terms of Economic Value

• Return to Example Bapak A
• Diagram the loan (Cash Flow Diagram)
• The investment company’s perspective is shown
$20,000 is
received here

$20,000 now is
economically
equivalent to $21,800
T=0 t = 1 Yr one year from now IF
the interest rate is set
$21,800 paid to equal 9%/year
back here
• $20,000 now is not equal in magnitude to $21,800 1
year from now
• But, $20,000 now is economically equivalent to
$21,800 one year from now if the interest rate is 9% per
year.
• Another way to put it is ……..
• If you were told that the interest rate is
9%....
• Which is worth more?
• $20,000 now or
• $21,800 one year from now?
• The two sums are economically equivalent
but not numerically equal!
• To have economic equivalence you must specify:
• Timing of the cash flows
• An interest rate (i% per interest period)
• Number of interest periods (N)
• Two “types” of interest calculations
• Simple Interest
• Compound Interest
• Compound Interest is more common worldwide and applies
to most analysis situations
• Simple Interest
• Calculated on the principal amount only
• Easy (simple) to calculate
• Simple Interest is:

(principal)(interest rate)(time)
$I = (P)(i)(n)
• Example :
•Borrow $1,000 for 3 years at 5% per year
• Let “P” = the principal sum
• i = the interest rate (5%/year)
• Let N = number of years (3)
• Simple Interest
• DEFINITION
• I = P(i)(N):
• I = $1,000(0.05)(3) = $150.00
• Total Interest over 3 Years
• Year-by-Year Analysis: Simple Interest
• Year 1
• I1 = $1,000(0.05) = $50.00
• Year 2
•I2 = $1,000(0.05) = $50.00
• Year 3
• I3 = $1,000(0.05) = $50.00
• “Accrued” means “owed but not yet paid”
• First Year:
P=$1,000

1 2 3

I1=$50.00

$50.00 interest accrues but is not paid

• Year 2

P=$1,000

1 2 3

I1=$50.00 I2=$50.00

$50.00 interest accrues but is not paid

• $150 of interest has accrued
P=$1,000

1 2 3

I1=$50.00 I2=$50.00 I3=$50.00

Pay back $1,000

The unpaid interest did not earn interest + $150 of
over the 3-year period interest
• In a multiperiod situation with simple interest:
• The accrued interest does not earn interest
during the succeeding time period.
• Normally, the total sum borrowed (lent) is paid
back at the end of the agreed time period PLUS the
accrued (owed but not paid) interest.
• Compound Interest is much different
• Compound means to stop and compute
• In this application, compounding means to
compute the interest owed at the end of the period
and then add it to the unpaid balance of the loan
• Interest then “earns interest”
• To COMPOUND – stop and compute the associated interest
and add it to the unpaid balance.
• When interest is compounded, the interest that is accrued at
the end of a given time period is added in to form a NEW
principal balance.
• That new balance then earns or is charged interest in the
succeeding time period
• Assume:
• P = $1,000
• i = 5% per year compounded annually
(C.A.)
• N = 3 years
• For compound interest, 3 years, we have:

P=$1,000
Owe at t = 3 years:
$1,000 + 50.00 + 52.50 +
1 2 3 55.13 = $1,157.63

I1=$50.00
I2=$52.50

I3=$55.13
• For the example:
• P0 = +$1,000
• I1 = $1,000(0.05) = $50.00
• Owe P1 = $1,000 + 50 = $1,050 (but we don’t
pay yet!)
• New Principal sum at end of t = 1: =
$1,050.00
• Principal and end of year 1: $1,050.00
• I1 = $1,050(0.05) = $52.50 (owed but not paid)
• Add to the current unpaid balance yields:
• $1,050 + 52.50 = $1,102.50
• New unpaid balance or New Principal Amount
• Now, go to year 3…….
• New Principal sum: $1,102.50
• I3 = $1102.50(0.05) = $55.125 = $55.13
• Add to the beginning of year principal yields:
• $1102.50 + 55.13 = $1157.63
• This is the loan payoff at the end of 3 years
• Note how the interest amounts were added to form a
new principal sum with interest calculated on that new
amount
• Five plans are shown that will pay off a loan of $5,000 over 5 years with
interest at 8% per year.
• Plan1. Simple Interest, pay all at the end
• Plan 2. Compound Interest, pay all at the end
• Plan 3. Simple interest, pay interest at end of each year. Pay the
principal at the end of N = 5
• Plan 4. Compound Interest and part of the principal each year (pay 20%
of the Prin. Amt.)
• Plan 5. Equal Payments of the compound interest and principal
reduction over 5 years with end-of- year payments
•.

Note: The following tables will show the five approaches. For now, do
not try to understand how all of the numbers are determined (that will
come later!). Focus on the methods and how these tables illustrate
economic equivalence.
• Simple Interest: Pay all at end on $5,000 Loan
• Pay all at the End of 5 Years
• Principal Paid at the End (balloon Note)
• 20% of Principal Paid back annually
• Equal Annual Payments (Part Principal and Part Interest
• Plan 1 Simple interest = (original principal)(0.08)
• Plan 2 Compound interest = (total owed previous year)(0.08)
• Plan 3 Simple interest = (original principal)(0.08)
• Plan 4 Compound interest = (total owed previous year)(0.08)
• Plan 5 Compound interest = (total owed previous year)(0.08)
• Note that the amounts of the annual payments are
different for each repayment schedule and that the total
amounts repaid for most plans are different, even
though each repayment plan requires exactly 5 years.
• The difference in the total amounts repaid can be
explained (1) by the time value of money, (2) by simple
or compound interest, and (3) by the partial repayment
of principal prior to year 5.
M A R R

• An investment is a commitment of funds and resources in a project

with the expectation of earning a return over and above the worth of
the resources that were committed.
• Economic Efficiency means that the returns should exceed the
inputs.
• In the for-profit enterprise, economic efficiencies greater than 100%
are required!
 MARR
• A firm’s financial managers set a minimum interest rate that
that all accepted projects must meet or exceed.
• The rate, once established by the firm is termed the
Minimum Attractive Rate of Return (MARR).
• The MARR is expressed as a percent per year.
• Numerous models exist to aid a firm’s financial managers in
estimating what this rate should be in a given time period.
• In some circles, the MARR is termed the Hurdle
Rate.
• Capital (investment funds) is not free.
• It costs the firm money to raise capital or to use
the owners of the firm’s capital.
• This cost is often expresses as a % per year.
• Assume you want to purchase a new computer.
• Assume you have a credit card that carries an 18% per year
interest rate.
• If you charge the purchase, YOUR cost of capital is the 18%
interest rate.
• Very high!
• Firms raise capital from the following sources:
• Equity – using the owner’s funds (retained
earnings, cash on hand–belongs to the owners)
• Owners expect a return on their money and
hence, there is a cost to the firm
• DEBT – the firm borrows from outside the firm
and pays an interest rate on the borrowed funds
• Financial models exist that will approximate the
firm’s weighted average cost of capital for a given
time period.
• Once this “cost” is approximated, then new
projects up for funding MUST return at least the
cost of the funds used in the project PLUS some
additional percent return.
• The cost is expressed as a % per year just like an
interest rate.
• First, start with a “safe” investment possibility
• A firm could always invest in a short-term CD paying around 4-5%
• But investors will expect more that that!
• The firm should compute its current weighted average cost of capital (See Chapter
10)
• This cost will almost always exceed a “safe” external investment rate!
• Assume the weighted average cost of capital
(WACC) is, say, 10.25% (for the sake of
presentation)
• Certainly, the MARR must be greater than the
firm’s cost of capital in order to earn a “profit” or
“return” that satisfies the owners!
• Thus, some additional “buffer” must be
provided to account for risk and uncertainty!
• Start with the WACC…
• Add a buffer percent (?? Varies from firm to firm)
• This yields an approximation to a reasonable
MARR
• This becomes the Hurdle Rate that all
prospective projects should earn in order to be
considered for funding.
 RoR - %

Acceptable range for new

projects

MARR - %

Safe Investment WACC - %

0%
• Assume a firm’s MARR = 12%
• Two projects, A and B
• A costs $400,000 and presents an estimated 13%
per year.
• B cost $100,000 with an estimated return of 14.5%
• What if the firm has a budget of, say, $150,000?
• A cannot be funded – not sufficient funds!
• B is funded and earns 14.5% return or more
• A is not funded, hence the firm loses the OPPORTUNITY to
earn 13%
• This often happens!
• A common question most often asked by investors is:
• How long will it take for my investment to double in
value?
• Must have a known or assumed compound interest rate in
advance
• Assume a rate of 13%/year to illustrate….
• The Rule of 72 states:
• The approximate time for an investment to double in
value given the compound interest rate is:

• Estimated time (n) = 72/i

• For i = 13%: 72/13 = 5.54 years
• Likewise, one can estimate the required interest rate for an
investment to double in value over time as:

• i approximate = 72/n
• Assume we want an investment to double in, say, 3 years.
• Estimate i – rate would be: 72/3 = 24%
 COMPUTER SOLUTIONS
• Use of a spreadsheet similar to Microsoft’s Excel
is fundamental to the analysis of engineering
economy problems.
• Appendix A of the text presents a primer on
spreadsheet use.
• All engineers are expected by training to know
how to manipulate data, macros, and the various
built-in functions common to spreadsheets.
• Excel supports (among many others) six
built-in functions to assist in time value of
money analysis
• Master each on your own and set up a
variety of the homework problems (on your
own)
• To find the present value P: PV(i%,n,A,F)

• To find the future value F: FV(i%,n,A,P)

• To find the equal, periodic value A:

PMT(i%,n,P,F)
• To find the number of periods n:
NPER(i%,A,P,F)
• To find the compound interest rate i:
RATE(n,A,P,F)
• To find the compound interest rate i:
IRR(first_ cell:last_ cell)
• To find the present value P of any series:
NPV(i%,second_cell_last cell) + first cell
• These built-in Excel functions support a
wide variety of spreadsheet models that
are useful in engineering economy
analysis.
End of Lecture
Good Luck !